Margin Call: Understanding Options Trading

Understanding Margin Calls in Trading: A Comprehensive Guide

Trading on margin offers a variety of potential benefits, such as the ability to borrow money from your broker to buy securities. While margin trading can increase your returns, you are also exposing yourself to risk. A margin call can increase the probability of your losses and possible liquidation of your account. In this article, we delve into the intricacies of margin calls and provide key insights on how to avoid them.

What Is a Margin Call?

When a trader receives notification from his broker that the money in their trading account is insufficient to maintain an open position, this is referred to as a margin call or maintenance call. A margin call may force the trader to exit positions to lower the needed maintenance margin or provide extra Cash to balance the account.

3 Types of Margin Calls

There are three types of margin calls a trader can get. Let's take a closer look at each type:

1. Federal (Initial) Call

Also known as initial calls, this type of margin call occurs when an investor cannot meet the minimum margin requirement for a purchase as stipulated by Regulation T. This provision states that an investor may borrow up to 50% of the purchase Price of securities using a loan from a broker-Dealer. When the amount in the trading account falls below 50%, the trader receives a federal call.

2. Maintenance (House) Call

This margin call occurs when the value of an investor’s account equity drops below a specified minimum percentage of the account value. For example, if a broker demands a maintenance margin of 25%, this means the minimum equity amount in the margin account must be valued at 25% or more.

3. Exchange Call

Also known as a house or brokerage call, this margin call occurs when account equity drops below a minimum percentage of the account's value. House calls are sensitive to Market volatility because the maintenance requirement is based on the shares’ Market value and not the purchase Price. When a margin call is placed, the trader is expected to fund the account to cover margin shortfalls within two to five business days or your account positions may be partially or fully liquidated to cover the margin loan.

What to Do After a Margin Call

When you receive a margin call, there are several actions you can take to prevent your account positions from being partially or fully liquidated. Here's a breakdown of what you can do:

1. Deposit Cash

Funding your margin account is your first option when you get a margin call from your broker. It is advisable to have this money handy before you start margin trading, and always deposit above the minimum maintenance.

2. Deposit Securities

You can choose to deposit fully paid-for shares of stock as additional collateral for your margin loan. To determine the number of shares needed, divide the margin call amount by the difference between the loan value and maintenance requirement of the stock you plan to deposit.

3. Liquidate Stock

You can liquidate stock in your account to raise money to meet the maintenance requirements. Calculate the amount needed by multiplying the value of the stock sold by the maintenance requirement for the remaining shares in your margin account.

Practical Example of a Margin Call

The Table above illustrates how a margin call works in a practical scenario. It highlights the steps you can take to satisfy a margin call and avoid potential liquidation of your account positions.

How to Avoid a Margin Call

To prevent the stress of margin calls and potential financial repercussions, it is crucial to take proactive measures to reduce the likelihood of receiving a margin call. Here are some Strategies to consider:

• Have enough Cash: Keep a sizeable Cash reserve in your account as backup against a sharp decline in the value of your loan collateral.
• Decide on a personal trigger: Maintain extra liquid resources to add funds or securities to your margin account when needed.
• Monitor your account closely: Keep a close eye on your account and set up alerts for sharp declines in stock value.
• Set your own maintenance margin: Establish a maintenance margin above your broker's requirement to mitigate margin call risks.
• Use a margin calculator: Utilize a margin calculator to determine sufficient amounts needed to meet maintenance requirements.

Watch for a Margin Call

Leverage in trading can offer potential profits but also comes with the risk of significant losses. To avoid a margin call, it is essential to prioritize risk reduction over profit maximization by closely monitoring your account, setting higher maintenance requirements, and maintaining adequate reserves in your margin account.

Frequently Asked Questions